Loeb further predicts that Herbalife’s stock will trade at a beaten-down price only for so long. And he deemed it “preposterous” that the Federal Trade Commission has been sitting on a pyramid scheme for three decades without realizing it.

Rather than attempt any further summary, read it in his own words below. For those who’re interested, the letter also reveals that Third Point Offshore Fund Ltd. finished 2012 with a 21.2% gain, capped by a 9.2% rise in the fourth quarter.

New Equity Position: Herbalife (HLF)

Herbalife is a leading provider of weight management and nutritional supplements operating in more than 80 countries through a network of independent distributors. The stock declined by nearly half last month following controversial assertions made by a short seller about Herbalife’s business model and practices. Third Point has a different view and holds about 8% of Herbalife outstanding common stock, which we acquired mostly during the panicked selling that followed the short seller’s dramatic claims.

Based on its strong financial performance, Herbalife is a classic “compounder” – a well-managed company that sustains consistent top-line growth, has a leading market position, and steadily increases margins, earnings per share and free cash flow while demonstrating shareholder-friendly behavior. Since going public in 2004, Herbalife has increased revenue at a double digit rate for seven of the past eight years, expanded gross and operating margins, leveraged operating expenses, and introduced more premium products. Earnings per share have increased by approximately 20-50% each year since 2004, with the exception of 2009. Led by CEO Michael Johnson, management has also used the company’s ample free cash flow to de-lever its balance sheet and shrink the share count by nearly 25%. This type of steady non-cyclical growth is hard to find and puts Herbalife at the head of the compounders’ class.

With results like these, the case against Herbalife rests on a bold claim that the company is a fraud. The short seller’s lengthy argument against the Company can be boiled down to three principal smoking guns: the first, a claim that Herbalife has been operating an “illegal pyramid scheme” under the nose of the Federal Trade Commission for the past 32 years; the second, that Herbalife’s loyal customer and distributor base has been exploited and harmed despite the low number of consumer complaints and generous company return policies; and the third, a claim that Herbalife’s products are commodities sold at inflated prices not supported by sufficient levels of advertising or R&D.

Taken in reverse order, the third claim misses an essential truth that invalidates the indictment. No one believes Starbucks is a scam because you can buy a cheaper cup of coffee at your local bodega. A key contributor to Herbalife’s growth has been its distributor-led “Nutrition Clubs”, where consumers can purchase single servings of the Company’s signature beverages. The short seller’s assertion ignores the significant value customers place on every consumer brand and its community “experience” – whether at a Herbalife Nutrition Club, a Starbucks, or a corner bar. The markup is merited by community and brand identity, not by the commodity itself.

The second claim seems similarly dubious. The FTC, by all accounts, receives a very low volume of complaints annually about Herbalife – fewer than forty per year – and we find it hard to believe the short seller’s theory that hundreds of thousands of people who have been scammed supposedly are too ashamed to speak up. Herbalife is well-known for its generous return policies, buying back product from exiting distributors for up to twelve months. The Company repurchases an average of only 1% of sales volume pursuant to this policy. It is difficult for us to understand why the buyback volume would be so low if there are in fact so many unsatisfied consumers and distributors who presumably would not hesitate to be reunited with their cash.

The pyramid scheme is a serious accusation that we have studied closely with our advisors. We do not believe it has merit. The short thesis rests on the notion that the FTC has been asleep at the switch, missed a massive fraud for over three decades, and will shortly awaken (at the behest of hedge fund short seller) to shut down the Company. We find this thesis to be preposterous, particularly since the FTC has been sensitive to frauds of this kind. Since 1997, the FTC has brought 13 separate cases against alleged pyramid schemes. None of the companies that the FTC pursued had been in business for more than ten years and 11 of the 13 companies involved were less than five years old, suggesting the FTC actively protects consumers subjected to this type of behavior. The FTC has also aggressively pursued enforcement actions against similarly odious “deceptive business opportunity schemes” [see www.ftc.gov/opa/2012/11/lostopp.shtm] under the “Business Opportunity Rule” (although this rule does not apply to multi-level marketers such as Herbalife).

All multi-level marketers (MLMs) by definition operate under a so-called “pyramid” structure and have some internal consumption, facts which do not render them patently illegal, as FTC guidance makes clear. [See http://ftc.gov/os/comments /bizoprevised /comments/535221-00114.pdf]. Our analysis shows that the current, well-vetted regulatory framework provides plenty of room for multi-level marketers to conduct business legally, and we believe Herbalife operates squarely within the FTC’s boundaries. For example, the company does not directly pay distributors for recruiting new ones. We also understand that Herbalife has a series of internal policies in place (based on a 1979 case involving Amway) designed to reduce the possibility of abuses that have been identified in other MLM structures.

Do such policies eliminate all possibilities of bad behavior? Most likely they do not, especially at a company with so many distributors. By the Company’s own admission, past irregularities and misbehavior have been detected and corrected. While the short seller’s presentation was lengthy, it presented no evidence to show that Herbalife has crossed a line that would compel regulators to shut it down. Indeed, there was very little “new” news in the presentation and when pressed in later interviews, even the short seller conceded that the FTC was not looking at Herbalife’s practices. In our experience, expert regulators like those at the FTC do not respond to sudden pressure from hedge fund whistleblowers by acceding blindly to their demands. Finally, even if there were some regulatory intervention that changed how the company does business, we are comforted by the fact that 80% of Herbalife’s revenues come from overseas.

So we return to our compounder thesis, available at an attractive discount, probably for a limited time only. We believe that continued strong operating performance combined with disciplined capital return could easily send the stock back towards its April highs. Let’s not forget: the business itself is performing well. Volume, revenue and earnings are all growing double digits and the balance sheet is largely unlevered. Management has a history of returning 100% of net income to shareholders in the form of dividends and buybacks. If management were to deploy its existing $950 million buyback authorization in the $40-45 range (only taking leverage to approximately 1.5x), we estimate that run-rate EPS for 2013 could be $5.50-5.70 using the reduced share count. Applying a modest 10-12x earnings multiple suggests Herbalife’s shares are worth $55-$68, offering 40-70% upside from here and making the company a compelling long investment for Third Point. Given that the Company has historically traded more in the 12-14x range (and traded at 16-20x earnings through much of 2011 and early 2012), the opportunity for the Company to tell its side of the story tomorrow at its Analyst Day in New York, and the significant short interest, we believe shares could even trade well above our current price target.

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There are 2 comments

JANUARY 9, 2013 9:06 P.M.

GnuRich wrote:

Ackman has clearly illustrated the scheme with economic evidence. HLF says that their retail customers are distributors that buying and consuming the product and are signing on to get the 25% discount. But the product is all over eBay at a 50% discount. It's pretty clear that distributors are paying for their paycheck then dumping this stuff. By contrast, as was shown, the comparable GNC product is trading at the same price on eBay as in the store. Not to mention it is the same price as the HLF product, which makes sense as they are actually equivalent commodities. Also, HLF says they realize that most of the product is being bought by distributors for consumption to get the 25% discount, then they obviously realize booking the retail sales at 100% is fraudulent. The Ackman case is just so clear. But, I thank these folks who think the opposite because the puts just keep getting cheaper.

JANUARY 9, 2013 9:21 P.M.

Warren B wrote:

Lots of stuff is for sale on eBay for less than what it sells for at stores. That part of the argument is stupid.

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.

Chris Dieterich has covered the U.S. stock market for The Wall Street Journal and Dow Jones Newswires. He is a graduate of Regis University and the Missouri School of Journalism.